About Debt and the Option to Extend Debt Maturity

Marco Realdon

Discussion Papers from Department of Economics, University of York

Abstract: Both borrowers and creditors often have an implicit option to extend debt maturity as the debtor approaches financial distress. This implicit "extension option" is associated with the possibility for debtors and creditors to renegotiate the debt contract in the hope that extending debt maturity may allow the debtor to overcome temporary liquidity problems. This paper analyses and evaluates such "extension" option in a time independent setting with constant nominal capital structure and in a time dependent setting with not constant nominal capital structure. The "extension option" is shown to significantly increase the value of equity and has a non-negligible impact on debt credit spreads. The "extension option" can also increase the short-term credit spreads of outstanding debt and, in this respect, it ameliorates the shortcoming typical of structural models of credit risk, i.e. the under-prediction of short term credit spreads. The value of the extension option is very sensitive to different possible exercise policies. Four such policies are illustrated, encompassing cases in which the debtor extorts concessions (to extend debt maturity) from creditors and cases in which creditors make self interested concessions (to extend debt maturity). In general, when default is triggered by the "worthless equity" condition, the value of the extension option is much higher than when default is triggered by a liquidity shortage. The option to renegotiate debt maturity is of interest because extending debt maturity can decrease debt value even without cutting promised coupon payment, i.e. without giving up part of the tax shield associated with coupon payments.

Keywords: Corporate debt; Debt maturity; Default barrier; Renegotiation; Credit spread (search for similar items in EconPapers)
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